January 30, 2012

I’m sure you’ve noticed that I haven’t written much about clearing lately. (And yes, I can hear the Hallelujah Chorus.) Simple reason, really. Most of the clearing related news warrants schadenfreud, and an “I told you so” response. I enjoy a good Lulz as much as the next guy, but I know it gets old.

1. The advocates of mandates, notably GiGi and Timmy! asserted repeatedly that clearing would reduce the connectedness of the financial system, and in particular, would reduce the importance of big banks in those connections. I argued in response that clearing mandates would just change the topology of the network; that it would remain densely connected; big banks would still be tightly connected; and that the new topology was not obviously less systemically risky than the old one.

From the article:

Where do you find the spare $2 trillion needed as collateral for cleared swap trades?

With new regulation in the US and Europe set to move the bulk of the over-the-counter derivatives market towards central clearing from next year, swap buyers and dealers will soon be faced with that very question. Many custody banks believe they could provide the answer.

Already heavily involved in the plumbing of the clearing market, custodians act for almost every major financial services firm without a custody arm – including most dealers and every clearing house.

Most also offer collateral management services, including securities lending and collateral improvement – the process of turning less-liquid securities into eligible collateral to post as surety in transactions.

This experience could prove invaluable with the advent of new swap clearing rules, which come in with the expected implementation of the Dodd-Frank Act in the US from early next year, increasing the demand for collateral transformation services.

Executing brokers are expecting to generate strong post-trade revenues from collateral transformation – but the custody banks are the ones holding the collateral.

This is a huge opportunity for custodians, and several are already investing anywhere between $50m and $100m to position themselves.”

In other words, big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services.

2. The advocates of mandates argued that it would reduce leverage in the system. I responded repeatedly that this was not at all obvious, and that the most likely effect would be to transform the nature of leverage. The big move to collateral transformation makes it abundantly clear that this is in fact happening. I go into this in much more detail in my forthcoming Journal of Applied Corporate Finance article titled “Clearing and Collateral Mandates: The New Liquidity Trap?”

Credit means credit risk. So the clearing mandate has not eliminated credit risk from the derivatives market, or even reduced it sharply. It has just transformed it, relocated it. And it has definitely not eliminated derivatives-related credit risk from big banks. Indeed, it is moving more risk to some big banks. BNY-Mellon and JP Morgan are also the most important settlement banks, and play a vital role in the repo market. This is already a source of systemic risk. These banks are arguably the most important pieces of the financial infrastructure, and these developments will make them even more important, and also concentrate more risks from disparate markets (e.g., repo and derivatives) in them.

3. The advocates of mandates asserted that it would make the derivatives market less concentrated and more competitive (although nb these are NOT equivalent). From the article:

Tech-heavy effort

Among the most ambitious to gain business in the swaps market is BNY Mellon, the world’s largest custodian with $25.8 trillion of assets under custody. The bank sees its existing footprint as a springboard towards dominance in the collateral services market for OTC derivatives.

[A director] for collateral management and clearing at BNY Mellon in London, believes it will be a tech-heavy effort. He said: “According to recent Isda Margin Survey figures, roughly 80% of collateral used in the OTC swaps market is cash, with about 15%-20% being fixed-income securities.

If even 20% of the estimated extra $2 trillion of collateral required to clear OTC swaps via central counterparties is in the form of securities, that puts a big onus on the collateral managers to offer smart, quick systems capable of handling huge draws on client collateral daily.”

Rival US custodian State Street has also been boosting its presence in the cleared derivatives markets, launching a swaps clearing operation in September. In a signal of intent, the bank has quietly begun hiring senior futures brokers from established rivals.

Charley Cooper, senior managing director at State Street Global Markets, said: “State Street’s unconflicted approach combined with the operational efficiencies gained from clearing with a custodian, gives us a significant edge in the emerging clearing marketplace.”

A senior derivatives banker said that clients are already looking at custodians as a viable counterparty.
He said: “In the past six months, we’ve seen growing migrations to the custodial clearing business.

Some have a better credit rating than almost every investment bank, and it’s unlikely they will be subject to capital ring-fencing regulations.”

He said that if a major custodian is able to convert even half of its existing custody clients into clearing clients, it could be looking at a share of anywhere between 10% and 20% of the OTC clearing market.”

The incumbents

But existing derivatives flow dealers – especially ones with large custody and treasury businesses – are unlikely to shy away from a revenue-generating opportunity.

Citibank, in particular, is hoping to combine a swaps clearing operation with its custody and treasury services in the US.

Jerome Kemp, global head of exchange-traded derivatives and OTC clearing at Citi, is in no doubt which direction the market is heading.

He said: “We’re looking at a re-dealing of the cards in the derivatives clearing space. Post-Dodd-Frank implementation, clearing will be led by the larger, well-capitalised banks.”

Citi hired aggressively to expand its futures commission merchant business last year, including the hire of Kemp, previously co-head of listed derivatives and clearing at JP Morgan, who arrived with a raft of colleagues.

Kemp thinks the next battleground for the bigger futures commission merchants, which will act as clearers for many firms on the buyside, could hinge on the bundling of services across clearing and asset servicing.

JP Morgan, meanwhile, is also looking to leverage its existing prime services footprint for its hedge fund clients for whom swaps clearing will be a new experience.

The bank has merged its listed and OTC clearing teams, and invested heavily in client roadshows and clearing masterclasses since the Dodd-Frank Act was passed in 2010.

For a lot of asset managers, who do not feel they are able to use prime brokerage services, it’s a big benefit to have someone who can act as a custodian and a clearer.”

So there is a big fixed cost to play in this game. The resulting scale economies tend to increase concentration. Moreover, there is a strong scope economy across collateral management and transformation services, and other custodial services. Meaning that the big custodian banks have a strong competitive advantage in providing the new collateral management and transformation services that will become a crucial component of the OTC derivatives markets.

It is particularly ironic that BNY-Mellon will be a major beneficiary of this. You might recall the execrable NYT piece (written by Louise Story) about the evil derivatives dealer cabal. One of the most memorable parts of the article was BNY’s whinging about its inability to break into the dealer space. Read this new piece and you can just imagine BNY execs rubbing their hands together in glee, throwing their heads back, and laughing an evil laugh. All your cabal belong to us.

So let’s summarize, shall we? Clearing mandates (and requirements to collateralize uncleared swaps) will result in the formation of new links between buyers and sellers of swaps (including dealer banks who do not offer custodial services) and a handful of major custodian banks. These links will involve the extension of credit, and hence the existence of derivatives-related counterparty risk in which big banks still have substantial exposure. If anything, the mandates will increase concentration in an important part of the derivatives market. Moreover, it will arguably increase the concentration of credit risk exposure in a handful of systemically important banks.

Well played! The actual results of Frankendodd will be the exact opposite of what was claimed by its tireless advocates (And yeah, I’m looking at you, Timmy! and GiGi. I’m trying not to look at Barney, but that’s a whole other story.)

I’ve learned a lot at the website about the complexity of central clearing and thank you for the clear thinking that you bring to this topic; however, won’t there be another effect. Won’t firms just use derivatives less.

I used to always believe that derivative usage was beneficial, then the crisis hit and I got a much closer look at how some participants had abused derivatives. How much worse off would we be if firms cut back on their derivative usage, at least the ones for which they are unwilling to tie themselves up in knots to meet their margin requirements.

Like I said, I’ve learned a lot from you and agree with much of what you say, but I’m left with the question of whether slowing the growth or reversing the growth of derivatives will really be that bad from a systemic risk standpoint.

@Highgamma–thanks. It depends on whether you think that derivatives use is good or bad. I think the answer is “both”, and the issue is whether this particular policy will hit the bad uses harder than the good ones.

I agree that some derivatives usage is used to reduce taxes or evade regulations. The social benefit of this is difficult to determine: it can be good, for instance, if it mitigates the effect of a pernicious tax law, but some of it involves just the use of real resources to secure a transfer. But much derivatives usage is intended to facilitate legitimate risk shifting.

Clearing mandates and collateral mandates are a very blunt tool, and I am highly skeptical that they will disproportionately affect the abuse of derivatives: good uses will be affected adversely too. Firms will still be attempting to achieve the same objectives; they’ll just use different ways to achieve them, and in many cases these alternatives will be far less efficient.

There were some papers in the 1980s that looked at the effect of margin changes on the composition of futures trading. Margin changes didn’t uniformly hit the intended target: speculators. Sometimes they resulted in a decline in hedging activity. Not directly on point, but an illustration that margin policies are a very imprecise tool at shaping how derivatives are used.

Insofar as systemic risk is concerned, it is by no means clear that even if derivatives usage is reduced that systemic risk will decline because (a) the new structures will have their own vulnerabilities (the focus of this post), and (b) people will substitute alternative ways to achieve the same objectives, and these will also have their systemic vulnerabilities.

Bottom line. My position all along has been that you just can’t engineer outcomes in these markets. Attempting to do so results in major unintended consequences, many of which are diametrically opposed to the stated objectives. That’s because this isn’t an engineering problem. It’s the problem of how a complex spontaneous order responds to an intervention. The market didn’t get the way it is by accident. It developed to accommodate the preferences and technologies of the market actors. Those haven’t changed. They will respond to the intervention by doing things that undo much of the intended effect.

I am trying to be the kind of economist Hayek was talking about when he said that “the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Our Sorcerer’s Apprentices thought they were designing a better derivatives market. They had no idea what the consequences of their actions would be. Maybe you’re right, and that bad use of derivatives will be especially constrained. But that really had very little to do with what they thought they were doing, and that would be the happiest of accidents, and something that I would definitely never bet on.

Professor,
I’m having trouble visualizing the chain between natural hedgers, their brokers, the banking dealers, the custodian banks trying to step into to serve as clearing banks under the new SEF rules, and then the interdealer brokers. Do you have, or can you point me to, a simple picture of the entities in today’s configuration and in the new setup with SEFs and Custodian Banks stepping in?

The clearing mandate has some wide gaps for OTC derivatives, and it will be easy for quants to structure look-alike derivatives that do not require clearing. There will be movement from standard OTC instruments to “structured products”. Counterparties will continue to trade bi-laterally without the increase cost (and risk) of JPMorgan and BNY standing in between. Dodd-Frank will have a tough time cracking down on all private transactions such as “corporate sales” and “supply agreements”, which is how a structure product can be created. SWP, do you care to speculate when the first major clearing house goes bust?

[…] The Streetwise Professor pretty much nails one of the big winners in the (regulatory mandated) move to OTC derivatives central clearing: big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services. […]

[…] Note: We have wondered aloud if securities lenders are really the right place to do these trades. Beneficial owners, as noted above, want to be “short and nimble”. But collateral transformation is driven by CCP collateralization and the banks wanting high quality paper for regulatory liquidity reasons. Both of these require long-term trades. No beneficial owner should want to end up like Dexia. The discussion is hitting the blogosphere too. Here is a post from “Streetwise Professor” worth taking a look at. […]

[…] crisis, moves many derivatives to central clearing houses, which will require traders to post more collateral. Also, central banks are buying up securities, both for their own investments and to funnel cash to […]